Security Characteristic Line

The comparison of a stock's excess return can be plotted against the market's
excess return on a scatter diagram using linear regression to construct a line
that best represents the data points. This regression line, called the security
characteristic line (SCL), is a graph of both the systematic and the
unsystematic risk of a security. The intercept of the regression line is the
alpha of the security while the slope of the line is equal to its beta.

Single-Index Model and the Capital Asset Pricing Model

The alpha of a portfolio is the average of the alphas of the individual

securities. For a large portfolio the average will be zero, since some stocks will
have positive alpha whereas others will have negative alpha. Hence, the alpha
for a market index will be zero.

Likewise, the average of firm-specific risk (aka residual risk) diminishes

toward zero as the number of securities in the portfolio is increased. This, of
course, is the result of diversification, which can reduce firm-specific risk, but
not market risk, to zero.

Hence, the alpha component and the residual risk tends toward zero as the
number of securities are increased, which reduces the single-index model
equation to the market return multiplied by the risky portfolio's beta, which is
what the Capital Asset Pricing Modelpredicts.

Profiting from Alphas with Tracking Portfolios

The decomposition of a stock's return into alpha and beta components allows
an investor to profit from stocks with positive alpha while neutralizing the risk
of the beta component. Suppose that a portfolio manager has identified,
through research, one or more securities that have positive alpha but the
manager also forecasts that the market may decline in the near future. The
positive alphas indicate that the stocks are mispriced, and, therefore, can be
expected to correct to their proper price in time.

To isolate the potential profits of the mispriced stocks, a portfolio manager

can construct a tracking portfolio, which consists of a portfolio that has a
beta equal to the portfolio with the positive alpha stocks, and sell it short. This
eliminates market risk, since if the market declines, then the shorted tracking
portfolio will increase in value by the same amount that the long position will
decline due to its systematic risk as measured by its beta. Hence, the
manager can profit from the positive alphas without worrying about what the
market will do. Many hedge funds use this long-short strategy to profit in
any market.